What You Can Do if You Have a Lousy 401(k)

It's a tough world out there for people hoping to retire. An employer-sponsored plan such as a 401(k) is a huge help, but bad plans can make it harder for people to retire than it should be. Some of the bells and whistles, such as a match from the employer, are extremely nice to have. Free money from a generous employer is great. But that may not be enough to make up for a plan with lousy investment options.

Most of the problems in bad 401(k) plans stem from high fees and poor investment choices.

Fees are everywhere

Workers who sign up for their employer-sponsored plan may have no idea what kinds of fees they're being charged. Last year, the Department of Labor instituted a rule that requires plan sponsors -- employers -- to disclose the fees charged to plan participants. Even so, this did not appear to enlighten workers about what they're paying in fees, since half of them had no idea how much they paid in 2012 -- the same percentage as the previous year, according to a study by LIMRA, an insurance consultant.

Average fees and expenses paid by plan participants in 2012 totaled 1.46 percent for small plans with 50 participants and less than $2.5 million in assets. For large plans with 1,000 participants and $50 million in assets, average fees were 1.03 percent, according to the most recent version of the 401(k) Averages Book and the Society for Human Resource Management.

The bulk of fees comes from the expenses related to investments. Fund companies bundle fees differently, depending on share class. One class of shares may have no built-in sales charge, but another share class may add that charge. Institutional share classes generally don't have 12b-1 fees built into the cost. These are "distribution fees" that pay for advertising and marketing costs of funds. Overall expenses will hinge on the investment choices made by the participant, but the share classes offered by the plan make a big difference.

Typically, the share class is identified in the name of fund, for instance, Columbia Mid Cap Index A indicates that class A shares are on tap for that plan. Class A shares typically charge a sales charge, also called a front-end load. The cost of the funds can be found in the prospectus or on the fee statement.

The R share class

While A, B and C share classes are generally sold to individuals who work with commission-based advisers, R shares are often found in retirement plans. Though R shares have no load or sales commission, they may have other expenses built in. Investors want to see higher numbers attached to the R, for example R4 shares rather than R1, according to Donald Jones, a director at Fiduciary Doctors in Phoenix, Ariz. "If it's an R1, R2 or R3, you can bet there is a lot of hidden expense built into that fund," he says.

The difference in cost between R1 and R4 share classes can be nearly a full percentage point, according to Jones. That may not sound like a lot, but it adds up year after year and can make a huge difference in how much you end up accumulating for retirement.

"I call it the rule of 1 percent -- if you take a difference of 1 percent lost through an improper share class and you multiply that over 35 years, participants have approximately $200,000 less at retirement," says Craig Morningstar, chief operating officer at Dynamic Wealth Advisors in Scottsdale, Ariz.

As an example, if you save $10,000 a year and earn a 6 percent return on average, you'll end up with $1,114,348 after 35 years. But if you only earn 5 percent net of fees, your nest egg will be worth $903,203 -- a difference of $211,145.

Spread across an entire plan, that represents a lot of money lining the pockets of investment professionals rather than the retirement accounts of workers.

Why would an employer pick share classes that are obviously to the detriment of their workers? In many cases, they wouldn't; they simply don't know how the financial industry works. "The plan sponsor is not the one choosing the share class.... Usually, the adviser or plan provider is helping select those," says Jones.

Bad investments

Unfortunately, plan sponsors may be nudged in the direction of adding investments that could benefit the investment provider more than plan participants.

"The revenue sharing they can build in is the most important to them," says Morningstar.

Revenue sharing occurs when plan providers get payments from investment fund companies for selecting particular mutual funds for 401(k) plans. Plan sponsors are often unaware that these conflicts of interest exist. "Many sponsors, particularly of smaller plans, do not understand whether or not providers to the plan are fiduciaries, nor are they aware that the provider's compensation may vary based on the investment options selected. Such conflicts could lead to higher costs for the plan, which are typically borne by participants," according to a 2011 report from the Government Accountability Office.

"The one who loses is the plan participant," says Morningstar. "It eats away at their retirement. The one who is responsible, the one with risk, is the plan sponsor and their personal assets. Usually, neither party knows (about the revenue sharing arrangements). It's a great deception," Morningstar says.

Plan sponsors have the option of hiring a professional fiduciary to oversee the plan. Though it's an added expense, it could save the plan and participants money in the long run.

A litigious solution

There is a remedy against plans that offer really egregious share classes when better options are available. But it's a nuclear-level response.

"Class-action lawsuits are almost always the most important and powerful action against the plan sponsor in the improper use of the share classes. Many times the plan sponsor was not aware, but the law does not allow them to be unaware," says Jones.

Every 401(k) plan is required to have a named fiduciary or a responsible fiduciary. Often the plan sponsor is listed. In that case, because the plan sponsor has a fiduciary duty to pick investments that are in the best interest of plan participants, plan sponsors open themselves -- and their personal assets -- up to a lot of risk.

"(Participants) have only one recourse: to sue the employer. And they win," Morningstar says. "Under ERISA Section 409, it states that a participant can be made whole for a breach of fiduciary duties."

ERISA refers to the Employee Retirement Income Security Act of 1974. The federal law establishes minimum standards for retirement plans offered in the private sector.

Some high-profile lawsuits in recent years have set the bar for the level of care required by fiduciaries to a retirement plan. They all boil down to a simple concept: "Are the people getting paid from plan assets performing an important service for plan participants? And are they getting compensated reasonably? Or are they getting overcompensated," says Marcia Wagner, managing director of The Wagner Law Group in Boston.

"This is an area where there has been some abuse, particularly, but not only, in the retail arena where fees were not transparent. There were 12b-1 fees and revenue sharing; it wasn't clear who was getting paid by whom and when," she says.

Other options than lawsuits

Most people probably don't want to sue their employer, and their employer probably doesn't want to offer a bad plan. Before talk of lawsuits begins, plan participants should approach their employer.

"Gather documentation and find other employees that have similar concerns. Provide documentation to the employer and ask to be involved," says Morningstar.

The site Brightscope.com puts 401(k) plans in context for participants. Many workers can see how their plan falls in line with similar-size companies in their industry. Viewing the plan in that context could nudge plan sponsors to make changes to a lackluster 401(k).

"Companies don't want to spend money that is not appreciated by the employees," says David Littell, co-director of the New York Life Center for Retirement Income at the American College of Financial Services in Bryn Mawr, Pa. They are spending money on it and if they find out no one is happy with it, then they will make it better."

Working around a suboptimal plan

Rick Meigs agrees that employees concerned about the quality of their employer's retirement plan should take their concerns to the employer.

"Remember that the boss also has to use the same crummy plan, so they may be motivated to make some fixes," says Meigs, who is president of 401khelpcenter.com, a retirement plan research site.

If fixing your company plan isn't possible, then married or otherwise committed couples could focus on fully funding the better plan in the family. However, if your employer offers a match, be sure to contribute enough to get that free money.

"Consider opening an (individual retirement account) or a Roth IRA at a low-cost provider and maximizing your contributions through it," says Meigs. The 401(k) could be used for overflow if you're able to save more than the maximum allowed in an IRA ($5,500 in 2013; $6,000 for those ages 50 and up).

Awareness helps as well. The minimum that employees need to build wealth are reasonable fees and a quality assortment of investments. The 401(k) can be the cornerstone of a retirement plan or just a piece of it. Knowing the strengths and limitations of your plan can help you draft the most effective investment strategy for a wealthy retirement.